The West Texas Intermediate (WTI) crude oil market went into contango back in June 2008 and reached an apex super contango in late December. (Fig. 1) Since then, investment firms, investors as well as producers have been stockpiling oil and booked a record number of vessels for storage seeking to profit from the contango effect in the oil market.

In fact, the WTI futures curve serves as a good indicator of the U.S. oil inventory levels since a contango typically coincides with higher inventory levels and vice versa. The latest inventory data certainly can attest to this relationship.

Bursting U.S. Inventory

In its most recent weekly assessment, U.S. Energy Information Administration (EIA) data show a surprising rise in petroleum stocks of 3.7 million barrels from the previous week despite freezing temperatures across Europe and the U.S. in recent weeks (Fig. 2).

At 331.0 million barrels, U.S. crude oil inventories are above the upper limit of the average range for this time of year. The aggregate inventory rise of 8.9 million barrels is also amongst the largest weekly aggregate increase ever.

In addition, FT.com reported that the U.S. strategic petroleum reserve is now full as of Dec. 27, 2009 adding to the already bearish tone in the market.

Costs & Profits

Contango trade is profitable if the spread is wide enough to cover the costs of holding crude stocks, namely storage and working capital. Such stocks are discretionary stocks built or drawn in response to prices, and particularly in response to forward price curve.

Discretionary stock building occurs “disproportionately” in the U.S. Northeast, particularly around New York, and in Northwest Europe, especially in the Antwerp-Rotterdam-Amsterdam (ARA) area where the world’s two active product futures exchanges, the NYMEX and the International Petroleum Exchange are based.

Storage costs money, but how much? The U.S. EIA estimated holding crude oil would cost a company about depending if it owns or rents storage. For gasoline, the costs would be $2 and $6 per barrel per year, or $0.01 per gallon per month:

A 26-Mile Long Oil Contango Trade

With on-land tank farms getting full, the discretionary stocks turn to oil tankers for floating storage. According to research by Gibson Shipbrokers, one in twelve of the world’s largest crude oil tankers are being used to store oil rather than transporting it.

Bloomberg gave a good visualization of this massive convoy:

“Those storage tankers, if lined up end to end, they would stretch for about 26 miles, enough to blockade the English Channel.”

More than half of the ships are in European waters, with the rest spread out across Asia, the U.S. and West Africa. Royal Dutch Shell Plc (RDS.A), BP Plc (BP); Goldman Sachs Inc. (GS), JPMorgan Chase & Co. (JPM); and Morgan Stanley were among those that sought vessels for storage.

145 Tankers & 127 Million Barrels at Sea

By one estimate, the crude stored at sea is enough to supply the 27- nation European Union for more than three days.

Shipbroker SSY estimated offshore worldwide, there are a total of about 145 vessels holding roughly 127 million barrels of crude oil and oil products at the end of December 2009. That is down from 161 ships with 141 million barrels in November.

Oil Crash by Contango Trade Unwind?

Attractive contango spread tends to incentivize traders buy up spot and nearby futures which inadvertently narrows the spread (Fig. 3). (Read more on what a flatting oil contango means here.)

The spread between the first and sixth Brent crude-oil contracts on ICE Futures has declined around 4% from 23% a year ago, and the spread to January 2011 is only around $7. The spread for heating oil also shrank to a low of around $2 from about $18 a ton in December.

Since oil storage trade is no longer as profitable, these tankers are expected to start offloading oil en masse. Based on the median estimate in a Bloomberg News survey of 15 analysts, traders and shipbrokers, about 26%, or 39 million barrels of the stored crude and oil products could be unloaded from offshore alone in the next six months.

One could only speculate at least some offloading from tank farms as well.

This is when some analysts predicted that the eventual storage trade unwinding could lead to a $10-oil scenario. Lower demand forecasts for oil by various agencies and analysts only add strength to the prediction.

Is the crude market destined for a crash by the contango trade unwinding?

In order to answer that, we need to first take a look at the current crude price dynamics.

Where Are Oil Prices Going?

After spiking to a 15-mnth high of above $83 per barrel from freezing temperatures across Europe and the U.S., crude oil for February delivery settled at $78 a barrel on the NYMEX last Friday, the lowest settlement since Dec. 23. Futures fell 5.7% in one week, the first weekly decline in five weeks.

Now, one of the biggest questions of the market is “Where are oil prices heading?” as no other commodity impacts the global economy in as far reaching as the price of oil.

Crude was weighed down by forecasts for weak demand by the International Energy Agency (IEA) and some disappointing U.S. earnings and economic data. Stronger dollar, forecasts of milder temperatures, and moves by China to stem the expansion of the world's fast-growing economy also affected crude futures.

A Crude Technical Correction

Still, by looking at the current crude oil price levels, one would think there is a shortage of supplies. But nearly all market indications and forecasts are quite to the contrary.

So, technically as well as fundamentally, oil prices are set for a correction as the cold weather abates and the reality of weak demand and high inventory set in. .

Oil volume in electronic trading on the volume totaled 645,000 contracts last Thursday, 14% above the average of the past three months. Open interest was 1.35 million contracts, the most since July 11 2008; the day crude oil reached a record $147.27 a barrel.

Meanwhile, the inverse correlation between oil and the dollar, which had eased briefly, seems to have resumed in recent sessions.

Currently, most of technical indicators are pointing downwards (Fig. 4). We could see crude trading with high volatility, inversely with the Dollar, testing the $77/b level with strong technical indicators point to around $74 and then we could see $73 tested.

Long Live the Contango Trade

A narrowing contango is typically perceived as a bullish sign for the oil market. The market correction along with continued optimism about global economic recovery could mean market participants will take it as a signal to go back into the oil storage trade.

The much worried CFTC position limits proposal does not seem as bad as the market had feared.

Weak dollar and inflation hedge should continue to encourage investment in commodities such as crude oil.

“Storage Interest Is Still There”

In addition, a portion of the discretionary stockpile is long term and strategic in nature, and thus tend not to respond to the futures curve as some may expect.

Based on a report by Platts dated Nov. 24, 2009, traders indicated storage interest, though not as strong as before, is still there. Morgan Stanley has chartered a newly built supertanker to possibly store up to 2 million barrels of diesel/gasoil to be delivered by the end of last November.

In the same report, Platts also noted broker reports showed 16 Very Large Crude Carries (VLCCs) have been taken by charterers such as Royal Dutch Shell (RDS.A), Barclays Capital (BCS), Vitol, and JPMorgan Chase (JPM) to store diesel/gasoil off European and Asian coasts.

Boon for Tank Farms

Oil inventories in the most industrialized countries remain well above average as global demand declines for the first time in a quarter of a century. And based on the latest EIA forecast, global oil stocks are expected to remain in the upper range of the five-year average through 2011. (Fig. 5)

According to FT.com, with high demand for storage space, owners have gained pricing power. In some cases storage operators are even turning away clients.

Most land storage capacity is held by oil majors and state-owned producers or in strategic government reserves. But a quarter is run by independent storage companies that rent out tanks to outside parties.

Some storage operators even have joined the futures trade themselves. Plains All American Pipeline (PPA) uses its 57 million barrels of storage for both lease and "contango market storage activities", according to its quarterly report.

Storage demand has also been boosted by new environmental rules that require blending of oil products with biofuels, multiplying the number of separate tanks necessary to serve consumers.

Tanker Sector Hit By Glut

The floating storage demand helped prop up tanker rates in 2009, but analysts estimate that the unwinding of oil storage trade would add to vessel supply and pushing rates for supertankers down more than 25% to an average of $30,000 a day in 2010. That would be below the break- even point of some ship operators such as Frontline Ltd. (FRO), who said its supertankers need $32,900 a day to break even.

So far, current prices for forward freight agreements, or FFAs, suggest that the average tanker rate for 2010 will come to $36,000 a day, down from $40,212 at the end of 2009, but still higher than the average $23,130 last year.

Meanwhile, the global tanker fleet is estimated to expand about 12% next year, of which 5% will come from ships released from storage.

Crude Long Term Intact

The IEA forecast for 2010 global crude demand to increase an anemic 1.6% or 86.3 million barrels a day from the group’s 2009 estimate.

For now, most analysts are holding the 2010 forecast between JP Morgan’s $72 to $90 by Goldman Sachs (GS), while Bank of America (BAC) expects oil to average $85/b through 2010.

Furthermore, BofA sees growing risk of a spike above $100/b by 2011 from a combination of loose monetary policy and dollar depreciation. Tightening physical oil supply and demand fundamentals in 2010 could also prop prices.

ExxonMobil (XOM) also indicated in its latest long-term energy outlook released last month that global energy demand will be around 35% higher in 2030 than it was in 2005. The forecast suggested:

“Oil remains the largest energy source through 2030, but natural gas will move into second place ahead of coal. In 2030, these three fuels will meet approximately 80% of global energy needs.”

Longer term, consistent positive reports in the U.S. and China will form a base for oil to appreciate. Of course, any geopolitical upset could easily send crude all the way up to the North Pole, then all bets will be off.

Investment Strategy

Contrarian & Long-term – The bearish outlook for the vessel sector could be a buying opportunity of operators like Frontline Ltd. (FRO) and Nordic American Tanker (NAT) as a recovery and emerging market play.

Short Term – Depending on investment horizon and portfolio composition, the other side of the contrarian/long-term vessel sector play would be to buy puts in the sector in anticipation of lower earnings this year.

: Storage operators such as Kinder Morgan Energy Partners (KMP) and NuStar Energy (NS) should stand to benefit from the expected high oil stocks through 2011.

: The long term oil market outlook would make integrated oil companies like Exxon Mobil (XOM), Chevron Corp. (CVX), and BP Plc (BP) with strong international presence and both E&P and refining/marketing operations worthy of investors consideration.

A combination of all or some of the aforementioned strategies could provide some interesting diversification and hedge as well.

Disclaimers: GuruFocus.com is not operated by a broker, a dealer, or a registered investment adviser. Under no circumstances does any information posted on GuruFocus.com represent a recommendation to buy or sell a security. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, investment advice or recommendations. The gurus may buy and sell securities before and after any particular article and report and information herein is published, with respect to the securities discussed in any article and report posted herein. In no event shall GuruFocus.com be liable to any member, guest or third party for any damages of any kind arising out of the use of any content or other material published or available on GuruFocus.com, or relating to the use of, or inability to use, GuruFocus.com or any content, including, without limitation, any investment losses, lost profits, lost opportunity, special, incidental, indirect, consequential or punitive damages. Past performance is a poor indicator of future performance. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, investment advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. The gurus listed in this website are not affiliated with GuruFocus.com, LLC.
Stock quotes provided by InterActive Data. Fundamental company data provided by Morningstar, updated daily.